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How a Lawsuit Against the World's Largest Private Equity Firms Puts a Spotlight on the Secretive and Powerful Industry

The Rise of the Financial Barbarians

by DARWIN BOND-GRAHAM

For a brief moment in the mid-2000s it looked as though private equity was unstoppable. Blackstone, KKR, TPG, Carlyle, Bain, and few other elite firms were divvying up the US economy’s publicly traded corporations amongst themselves. Every other week a new record setting deal was announced as companies of enormous value were purchased and taken private. Credit was readily available, interest rates on debt used to fund the buyouts was cheap, and the booming stock market made for innumerable lucrative targets. 2007 saw the largest volume of buyouts in history with $1.56 trillion in debt and equity funded transactions spread over 5,188 deals. It was an amazing level of activity, more than double the entire value of leveraged buyouts executed between 1990 and 1999. The private equity industry’s top managers reaped billions in personal profits and were celebrated in articles about their outlandish compensation, and their equally lavish consumption habits, including palatial estates, private islands, jet planes, and other markers of their princely status.

The most significant thing about this period was the lack of critical analysis of private equity’s methods, and the industry’s impact on the US economy. Although there were numerous examples of harm being done to the businesses they took control of, and to other stakeholders in these companies, including holders of subordinated corporate debt, employees, local communities, US taxpayers, and to less powerful shareholders, this side of private equity was not systematically assessed by scholars or the media. Nothing significant was done by regulators or lawmakers to stop, or even slow, the frenzied acquisitions.

With a few exceptions, regulators, lawmakers, academics, and the media were disinterested in actually understanding what the private equity industry was up to. Rather than scrutinize the industry’s methods —byzantine tax arbitrage strategies, the use of massively leveraged debt and dubious sources of collateral, the routine exploitation of corporate bankruptcy proceedings, the industry’s questionable informational advantages, political connections, and the interlocking financial interests among supposedly competing firms— lawmakers, regulators, and the media looked the other way.

Even with the financial crisis of 2008-2010, and the subsequent recession, most of the outrage and demand for change has been aimed at the CEOs of publicly traded commercial and investment banks, insurance companies, and mortgage lenders. As if by right of private equity’s legal existence beyond the reach of SEC regulators, and perhaps due to its ability to keep secrets from the DOJ, and maybe also still coasting on laudatory press from the just-concluded boom era, private equity has escaped mostly unscathed. Unlike other major financial industry players, private equity operates in a moral and legal universe little changed from the 1990s and 2000s. Mitt Romney’s run for the presidency has directed some media attention on issues of tax avoidance, and the harmful economic impact of some PE deals on workers and local communities, but even here the focus has been on Bain Capital and Romney, and not on the industry as a whole.

Now, however, a lawsuit making its way through federal court has the potential to refocus critical attention on the entire private equity industry. A recent ruling by the judge presiding over the case to unseal key documents —thanks to an intervention by the New York Times— has released information that is providing a detailed picture of the dozen or so major firms behind many of the biggest buyout deals of the previous ten years. It’s not a pretty picture. There appears to be strong evidence of criminal activity. In the very least the lawsuit is a detailed narrative of private equity’s biggest deals, including previously secret email messages between executives.

Dahl v. Bain Capital Partners is a class action representing the shareholders of companies taken private in 19 different LBOs and 8 related transactions between 2003 and 2007. Among these were some of the largest buyouts in history, making up a huge chunk of the mid-2000s buyout boom. The Plaintiffs allege that roughly a dozen of the largest private equity firms conspired for at least four years to rig the market for buyout transactions, purposefully working with one another through a “club deal” system, basically a price-fixing cartel, to depress the share prices of the companies they sought to take over. In doing so, say the Plaintiffs’ lawyers, led by the San Diego-based firm Scott + Scott, private equity firms reaped billions in extra profits, cheating shareholders of fair prices.

Lawyers representing the Plaintiffs tell the story this way: in the 1980s the corporate raiders, who were not yet calling themselves “private equity,” were engaged in robust competition.

“Historically, private equity firms fiercely competed. For example, KKR’s acquisition of RJR Nabisco in 1989 epitomized an era of robust competition. After Shearson Lehman Hutton, Inc. announced that it would acquire RJR Nabisco for $75 per share, a bidding war broke out between KKR, Shearson Lehman Hutton, and Forstmann Little & Co. Ultimately, KKR acquired the company for $109 per share – a 40% increase from the initial bid.”

The RJR Nabisco deal occurred at the height of the first LBO boom, from roughly 1987 to 1989, and served as the inspiration for Byran Burrough and John Helyar’s famous book Barbarians at the Gate. The boom also inspired the film Wall Street and forever marked the corporate raiders as unscrupulously greedy and aggressive. This era of buyouts died down during the early 1990s when subsequent restrictions in liquidity and credit slowed the entire US economy. In the downtime between then and the next buyout booms of the 1990s and 2000s, the shadowy managers of large private pools of capital laid low and worked hard to change their image from that of the avaricious pirate into respected investors and value adders. They wanted to look more like Warren Buffet than Micheal Milken.

Although many of the private equity groups operating back then made huge fortunes, some of them judged that these takings were too trim due to the competitive nature of their business. Credit and debt was so readily available, and the bull stock market was doing so well, that private equity firms were scrambling over one another to offer the highest possible prices for shares.

According to the Plaintiffs in Dahl v. Bain, the biggest private equity groups were determined to stifle these competitive dynamics. They vowed that profits taken in the next wave of LBOs, when credit conditions were again ripe for it, would not be limited by the otherwise hyper-oppositional nature of the buyout industry. That next boom arrived in about 2002, but really exploded in 2005, as easy access to cheap capital a given, and a select few investment banks, Goldman Sachs, Merrill Lynch, Citigroup, Barclays, Bank of America, and Morgan Stanley, looked to multiply their earnings with the higher fees generated by servicing private equity firms through LBOs. Some of the biggest public pension funds played an enabling role too, seeking higher returns on their capital they committed billions to private equity funds managed by just a few dozen of the elite shops.

Under these conditions, and seeking extreme profits, leaders of the biggest private equity houses formed a trust. “Rather than compete, Defendants agreed to work together to allocate deal outcomes and purchase the target companies at artificially suppressed prices, depriving shareholders of billions of dollars,” the 5th Amended Complaint in Dahl v. Bain argues. “Defendants fostered their conspiracy by regularly and explicitly affirming that ‘working together,’ instead of competing, best served their interests.”

As evidence of the private equity industry’s consensus against competition, the Plaintiff’s lawyers cite communications between Blackstone and KKR managers who bluntly explain how collusion can avoid past mistakes and produce bigger profits for their elite club. In one email a Blackstone manager explains, “the reason we didn’t go forward [on HCA] was basically a decision on not jumping someone elses [sic] deal and creating rjr [Nabisco] 2.”

HCA, the Hospital Corporation of America, was purchased for $37 billion in 2006 by Bain, KKR, and Merrill Lynch, against no meaningful competition after these winning firms allegedly secured pledges of non-competition from other elite private equity groups, all with the understanding that there would be a future quid pro quo. According to the Plaintiffs’ lawyers, the Bain/KKR/Merrill team asked Blackstone and other PE firms “to step down.” In an email that the Plaintiffs’ lawyers say describes the ethos of the industry, and affirmed their conspiracy, Blackstone’s president Tony James wrote to KKR’s co-founder George Roberts stating, “we would much rather work with you guys than against you. Together we can be unstoppable but in opposition we can cost each other a lot of money.” Roberts’ response was brief and clear: “agreed.”

That agreement about sums up the situation, as presented by the Plaintiffs in Dahl v. Bain. Internal documents, depositions, emails, and other evidence gathered during the factual discovery phase of the case support the theory of a massive conspiracy in which private equity’s leading firms gleefully gave up on competing with one another, and instead cooperated to allocate the total pool of the biggest buyout deals at artificially depressed prices. PE managers talked about scratching one another’s backs, expecting reciprocity, and providing paybacks for previous favors. Some firms maintained scorecards to keep track of the favors they owed, and what they in turn could expect from others. They asked one another to provide sham bids, later cutting the faux losers into lucrative deals only made possible by the absence of genuine competition. PE managers were careful to keep their conspiracy under wraps from the boards and executives of companies they were negotiating with for control, but they constantly referred to past deals and favors owed to one another when communicating about a specific buyout target. It became a complex web of favors, all to the benefit of a few private equity groups, and causing harm to shareholders and possibly others.

The Plaintiffs’ lawyers in Dahl v. Bain conclude that, “the nature of the private equity and investment banking industries made it a fecund environment for fixing the market.” They quote TPG’s co-founder David Bonderman who once observed that “consortia often limits bidding,” and that it ensures “less competition for the bigger deals.” Records handed over from Blackstone and KKR during the case’s discovery process echo this. Club deals promote a “less competitive deal environment,” says one Blackstone company document, while a KKR document explains that club deals “reduce competition in auctions.”

Those who know US antitrust law, and the high burden of proof it puts on these sorts of cases, have opined that the Plaintiffs in Dahl v. Bain will have trouble winning this case in federal court, even though their trove of records obtained from the industry is thick and rich with evidence of collusive behavior.

One of the lawyers involved in the case, speaking not for attribution, said he’s quite confident in their ability to prevail against the private equity firms, but acknowledged that the industry has hired the most powerful white shoe law firms to defend them, and have spared no cost toward this effort. Summary judgement is expected to be made in November, at which point the case could either be dismissed, or it will likely advance to the trail stage. If it goes that far, things will get very interesting.